Foreign capital inflows constitute part of the world's savings. Over the past three decades world savings in proportion to world income has fallen. The decline in world savings implies that not every country can maintain its level of domestic investments by increasing foreign capital inflows. The decline in foreign capital inflows to developing countries has necessitated structural adjustment in the form of an increase in export earning or a reduction in import expenditure. The national accounting identities imply that the adjustment must also raise national savings or reduce domestic investments. To maintain or increase rates of economic growth, the adjustment must be in the form of increased exports and increased national savings. Faced with changed circumstances countries now have no choice but to adjust. During 1980s governments of countries at all income levels and remarkably, of all ideological stripes have come to recognise the need for reforms to increase economic efficiency and flexibility.
At the most abstract level, adjustment programmes use changes in fiscal, monetary and sectoral policies; in regulations, and in institutions to alter relative prices and the level of spending and thereby redirect economic activities. The real exchange rate and the real interest rate are key relative issues because they both affect economic activity and saving as well as export and import and the rate of investment.
The scope of the economic reforms that are needed in the developing world varies widely. Some countries need to privatise state-owned enterprises or invest in education, health, and infrastructure. Everywhere these measures are based on macro-economic stability. Experience shows that the surest path to development is to improve policies in all these respects. Reforms have to deal with tradeoffs among macro-economic, political and even social policies. For example reform of the financial sector often calls for distressed financial institutions to be restructured. In the short run, this may raise public spending and make it harder to cut to budget deficit. Adopting positive real interest rates will lower the burden of credit subsidies but increase the cost of servicing domestic debt. Lower tariffs may initially reduce government revenues, whereas shifting from quantitative restrictions to tariffs will generally raise them. The net effect may be a bigger fiscal deficit.
Low inflation, external viability, fiscal discipline, financial stability and trade liberalisation constitute the key elements of a successful structural adjustment programmes. Expectations of high net rate of return to domestic investment are also essential, which may be achieved by eliminating debt overhang and removing barriers to the efficient allocation of resources within the economy. Again export growth is a determining factor for the viability of any economy. The most effective way to boost export is to liberalise imports in general, and trade liberalisation requires devaluation. It is thus particularly important to think of trade liberalisation and exchange rate adjustment as representing a policy package. Under a managed exchange rate system, import liberalisation necessitates the adoption of a realistic exchange rate policy to prevent the depletion of foreign exchange reserves.
The sequencing of the institutional restructuring at the macro level and the price liberalisation are required to be decided carefully. It is quite clear that it would be counter-productive to adjust and liberalise prices before economic agents have the incentives and sufficient freedom to respond. Regarding the sequencing of domestic institutional and price measures on the one hand and liberalisation of foreign trade and rate of exchange on the other, the flexibility of exchange rate movements and convertibility is required to be established at a relatively early state of the reform process.
However, structural adjustment has been complicated and slow. It remains specially difficult till now and all the more necessary because many developing countries were in dire financial straits. Countries needed external resources to offset the costs of adjustment. In the 1980s both the International Monetary Fund (IMF) and the World Bank helped finance economic programmes contributing to the adjustment process. Sixty-eight countries received long-term structural adjustment credits or loans from the World Bank between 1980 and 1992. Four Countries in the Indian subcontinent (Sri Lanka January 1979; Pakistan, November 1980; Bangladesh, December, 1980; India, November 1981) negotiated extended facilities adjustment programmes from the IMF. The adjustment strategies were designed to improve resources allocation, promote domestic investment and savings and strengthen external competitiveness. Key elements in these structural adjustment programmes were (i) increased public sector savings through tax reforms, reduced subsidies, wage restraint and realistic pricing policies by public enterprises (ii) increased private saving stimulated by higher real rates of interest (iii) more flexible adjustment of administered prices, such as agricultural procurement prices (iv) deregulation of industry (v) liberalisation of import controls and (vi) a commitment to maintain a realistic exchange rate to improve profitability and competitiveness of the export sector. Performances have been disappointing and mostly mixed in most of the economies which embarked structural adjustments. Exchange rate policies demonstrated unusual behaviour in some countries. However, all these countries could maintain their investment ratios despite a worldwide recession. During first half of the 1980s, growth rate remained unchanged in Bangladesh, rose marginally in Sri Lanka but fell in both India and Pakistan. But most part of 1990s and since the beginning of the new millennium growth rate have had on the path of slower but steady progress in these countries of the Saarc region.
Many developing countries in the world have made mixed progress towards restructuring trade reforms and exchange rate policies. In some cases, industrial policies in support of earlier import substitution strategies have maintained a protectionist stance, despite trade reforms. In other cases, inefficient financial systems continue to distort interest rates. In many countries, the failure of fiscal reforms in undermining the adjustment achieved so far and preventing further progress. Unsustainable fiscal deficits create economic uncertainty and in many cases, contribute to high inflation and subvert domestic financial system.
If reforms are to succeed investment must respond. Expectations of the business community are crucial to induce investment. The private sector may choose to wait and see, and let the government prove its commitment to the new policies. But this may be a vicious cycle, because if it takes too long to restore confidence for investment, the programme may fail for that reason alone. Credibility can be improved by first achieving macroeconomic stability. Often, the government has no choice but to rebuild its reputation and then guard it zealously. In this respect, it is important not to promise too much. It may also be necessary for policy makers to overshoot to prove that the reformers really do mean business.
Macroeconomic stability also makes reform of the financial sector more likely to succeed and thus supports the development of capital market that can foster private investment. The aim of financial reform is to increase savings and to see them used more efficiently, effectively and economically. In many cases, it involves removing interest rate ceiling to achieve positive real interest rates, and abolishing regulation that affect the size and condition of bank credit. Close link with world financial markets require domestic interest rates to be high enough relative to international rates for investors to keep their financial assets in the country. For this to work, macroeconomic stability and strong bank supervision are both needed to be in place.
Dr.Muhammad Abdul Mazid is a former Secretary to the Government and Chairman, NBR.
